For U.S. Residents with Foreign Trust Tax Status, Example

For U.S. Resident Owners/Beneficiaries of Foreign Trusts 

It is very common for U.S. taxpayers to form trusts — both domestic and foreign. And, trusts can be used for many different purposes. Some of the more common reasons to create a trust are:

• • • a basic Revocable Trust to hold real estate rental property;

    • a Charitable Trust for donation purposes;

    • a Life Insurance Trust to help fund avoid certain taxes at death;

    • a Dynasty Trust to transfer wealth to the next generation, and/or

    • Offshore Asset Protection Trust to try and protect assets by moving them offshore.

With foreign trusts, one of the most complicated aspects of foreign trusts is when a non-U.S. person becomes a U.S. resident and now has a complicated trust reporting exercise, they must complete each year by filing Forms 3520 and Form 3520-A. In general, foreign trust taxation and reporting is very complex (the IRS just issued proposed foreign trust regulations in May 2024). Let’s walk through some of the basics of a common example of what to do when a person is an owner of a foreign trust or a beneficiary of a foreign trust.

For a U.S. Resident Owner/Beneficiary of Foreign Trust, Example

Example of Foreign Trust Ownership

David recently became a Lawful Permanent Resident. Before becoming a Lawful Permanent Resident and while he was getting his affairs in order outside of the United States, David formed a non-grantor trust to hold some of his assets. Recently, David retained a new tax professional who reviewed David’s overseas assets and determined that David should have been filing certain forms to report the trust.

Which IRS Tax Forms to File?

Typically, David will file Form 3520 and Form 3520-A to report ownership of the foreign trust. Form 3520-A does require some bookkeeping and accounting skills, so taxpayers who are not familiar with preparing these forms may want to consider working with a tax professional.

Trust Filing Exceptions

The IRS has developed various exceptions for Taxpayers to report the foreign trust on Forms 3520/3520-A. For example, if the trust is a Canadian RRSP or RRIF, taxpayers still have to report it on Form 8938 and FBAR — but they are not required to file Form 3520. In addition, in 2020 the IRS released Revenue Procedure 2020-17 which is a much more general broad procedure assisting certain taxpayers who have tax-deferred retirement and other non-retirement tax-deferred trusts to help them avoid having to report on Form 3520 and 3520-A (although the FBAR and Form 8938 would still be required).

It is important to note, that the purpose of these exceptions is primarily to assist taxpayers who did not necessarily intend to form a trust, but are stuck in the trust matrix because, from a technical standpoint, their foreign pension or other tax-deferred retirement/non-retirement is considered a trust.

For U.S. tax purposes, these types of exceptions do not generally apply to your typical grantor or non-grantor trusts that are overseas. Thus, Taxpayers should go in with the idea that they presumably must file the form unless an exception applies as opposed to presuming that one of these exceptions will apply since they are primarily directed toward tax deferred and retirement ‘trusts.’

A Non-Grantor Trust Beneficiary

When a person is a beneficiary of a non-grantor trust, the reporting is more simplified than if they are an owner of a foreign non-grantor trust. That is because much of the complication with reporting a foreign trust involves reporting ownership. When a person is a beneficiary of a non-grantor trust then they have two main requirements. First, they must report the income that they received on their regular tax return. A beneficiary of a foreign non-grantor trust is taxed on the distribution — unless an exception, exclusion, or limitation applies. In addition, the taxpayer must also report the distribution on Form 3520 which is used to report large foreign gifts and trust distributions.

A Grantor Trust Beneficiary

For beneficiaries of a foreign grantor trust, it is usually the Grantor and not the beneficiary who reports the income. In general, the U.S. person owner of a grantor trust is attributed income about their ownership percentage of the foreign grantor trust. The idea of taxing the grantor on a foreign grantor trust and not the beneficiary is to prevent a wealthy grantor from assigning income to lower-income taxpayers such as younger family members who then turn around and gift the money back to the grantor — and the IRS loses out on the applicable taxes that should have been paid since at the end of the day, the money was distributed to the Grantor.

A Few Foreign Trust Issues to Consider

It can become very complicated when it comes to the taxation and reporting of foreign trusts. Let’s take a brief look at some of the common issues taxpayers face when it comes time to file their taxes.

U.S. Trust with Foreign Assets

If a U.S. trust has foreign assets, then a portion of the trust can be considered to be foreign and then the foreign requirements and disclosure rules would apply at least to the portion of the trust that is designated foreign.

Throwback Rule

A foreign trust can be subject to the throwback rules, which means that certain income in the trust may lose preferred status and/or there may be additional taxes and interest on the money that was previously DNI but was not distributed at that time and therefore recharacterized as UNI.

Revenue Procedures 2020-17

IRS Revenue Procedure 2020-17 may exempt reporting of trusts that are designated as tax deferred. Even though this may exempt the trust from having to file a Form 3520 or 3520-A, Form 8938 and the FBAR are still required to be filed, if applicable.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms and do not qualify for an exception or exclusion to FBAR filing, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.